Commodity supercyclers begin to squirm

For the last few months, MB has had to battle a torrent of Wall Street (and local) drivel about a “new commodities supercycle”. This notion was never well-thought through. It mistook a global inventory supercycle for some kind of MMT supercycle. It mistook post-pandemic supply-side frictions for some kind of inflation supercycle. It mistook a bit of goods buying by DM households for Chinese stimulus. It mistook US Keynesian exceptionalism for Austrian weakness. It mistook some bad weather for the Book of Revelations.

It has been a comprehensive intellectual failure piled upon unscrupulous bubble-blowing spruik. Now it has begun the great unwind:

We are far from done here, in my view. And the slow dawning of fear is appearing in the whites of Wall Street eyes. One of the last investment banks to join the pile-on was JPM and it sounds positively jittery now:

Within fixed income, we hold an overall bearish duration view focusing on real yields given the elevated gap between breakeven and real yields we noted last week. Even after the post-FOMC15bp increase,the level of the 10y US real yield at-75bp remains abnormally low in our opinion relative to growth and inflation backdrop. Indeed, our colleagues in US rates strategy have added outright shorts in USTs, at 10ymaturities where the negative carry headwind is somewhat less onerous. And the implication for the longer-end of the curve from lower inflation uncertainty from the Fed’s apparent ‘catch-up’ could also start to shift the directionality of the curve, similar to what occurred after the 2013 taper tantrum.

The position indicator of Figure12 also shows that there is further room for investors to exit previous steepeners in the 5s/30s part of the UST curve. In fact, according to Figure12 only a small portion of the previous steady shift to 5s/30s steepeners up until March 2021 appears to have been unwound so far. The strong reaction of the dollar and gold to lastweek’s FOMC meeting is indicative of the sensitivity of these two assets to US real yields. Given our thesis that the 10yUS real yield has plenty of upside from here, we see further upside for the dollar and downside for gold going forward. A stronger dollar has typically negative implications for commodities, but that impact should be secondary importance relative to the support we see in commodities from demand/supply imbalances and a further build up in investors’ commodity allocations.

We admit however that industrial metals such as copper are more susceptible to China’s credit tightening. Last week’s weakness in China’s domestic demand indicators is a reminder of the risk from China’s credit tightening and has been more important than the FOMC meeting for industrial metals. The muted reaction of value stocks to last week’s rise in bond yields immediately after the FOMC meeting is perhaps indicative of some fatigue with the value rotation theme, but we see higher bond yields as supportive over the medium term.

My view of what is coming is still very different from that of JMP. As both the Fed and China tighten simultaneously, plus the global inventory supercycle rolls over, the inflation outlook is going to fall fast. This will correct negative interest rates via falling inflation not rising yields.

This retreat of the inflation trade will steepen as commodity prices unwind as well. Investors that are now overweight the fallacious commodity supercycle narrative will jam the exits in a panicked exodus as both the Chinese and US economies slow materially into year-end.

This raises two questions for equities:

  • Can the value trade continue as inflation, yields, and commodities all going into hard reverse? No. There’ll be a reversal into growth which is already well underway. That’s still my 50% base case.
  • But, the combination of a simultaneously tightening Fed and China is so toxic for inflation that one has to worry that the entire relation trade won’t collapse into an outright growth scare and equities correction. That’s my 40% base case but it is rising fast.

If the latter does happen in an action replay of 2015, then we also need to ask what comes next. In 2015, we had the so-called Shanghai Accord in which China restimulated construction and the Fed backed off tightening.

We might be see something similar again. But nobody is friends anymore. So it is unlikely to be quite so coordinated nor constructive. The Fed will still have to factor in the coming Biden stimulus for the labour market and China clearly wants to get away from the strategic vulnerabilities that come with its stimulus addiction.

This is why am so very bullish DXY and so very bearish for commodities and AUD for the cycle ahead.

Houses and Holes
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